Every now and again, an elite club of European private equity real estate fund managers meets informally in central London to chew the fat. Unless you are already part of this long-standing exclusive circle, the chances are that you will not be invited.
I’ve never been invited, either, but I’m told that what is discussed behind closed doors reflects the big issues of the day. Certainly, one item that has been on the agenda in recent months is just how much GPs should push back against LPs on the issue of fees.
It is a crucial topic, because as INREV’s latest report on management fees and terms, published last month, suggests, many investors are increasingly in favour of upending the traditional fee structure in place in European funds.
People I have spoken with – including real estate fund formation lawyers – confirm a central tenet of INREV’s research. That is: LPs want change.
Specifically, they want change on both the management fee and performance fee (unless, that is, the fund manager happens to be considered of such standing that LPs are happy to go with the flow and sign up to the fee proposed).
There are many aspects of a private equity real estate fund’s fee structure to consider, but let us concentrate here on management fees.
The problem with management fees as they have evolved is that they were allowed to lurch away from being a way to pay overheads towards becoming a profit centre in their own right.
That is rightly to be stamped upon. However, there is a danger in shifting too far on this issue.
The case against low-balling the management fee is that in certain circumstances putting a premium on how low you can go on the management fee might persuade some managers to cut corners in managing optimally. This might especially be the case if the investors come to expect a report on Total Expense Ratio from funds. INREV’s study says the TER is currently reported to investors by 26 percent of funds that replied to INREV.
The concept of working out and relaying how much money is not being spent on investment has its benefits in terms of being a worthwhile measure. But the TER doesn’t tell an investor everything they need to know about the value of the management fee spend. Let’s say you are a pan-European fund manager who spends an extra €1 million on having an office in Luxembourg which saves the fund €50 million by being efficiently tax structured. All of a sudden, you are compared with a manager who charges less, but who might not get the same after-tax returns.
There is the temptation to cut corners and not open that second office in Luxembourg. The good fund manager knows that certain countries such as Germany and France are cracking down on some Luxembourg structures because they deem them as purely created to avoid paying tax in the country. Domestic tax regimes are therefore examining the structure of funds and investment vehicles to make sure they are “real”. That means a fund manager should populate the fund in Luxembourg with real people who actually spend some time there. It could mean opening two offices.
However, that same manager knows he must foot the bill in terms of paying for people to be in Luxembourg and will want to divert a certain amount of the management fee to cover the cost. In not bothering to establish a proper Luxembourg company, a rival fund manager may be saving costs and be able to budget for a lower management fee, but is that ultimately good for the investors?
This issue comes down to trust. LPs need to trust a manager is not looking to make money out of a management fee, but wants to spend for the greater good of the investor base.
The trouble is that the bond of trust has been considerably broken thanks to the mistakes made by many in the downturn. In addition, the supersized funds of the 2005 to 2007 period rightly have caused some investors to wonder whether the game changed to asset gathering over investing.
Whether LPs push really hard on the management fee issue (and other fee terms) remains to be seen because there have not really been many fund launches to gauge shifting industry norms.
It should become a lot clearer as the year unfolds. In the meantime, it is an issue that will continue to be spoken about in the upper echelons of the industry in Europe and at those secret meetings of the elite.